Amid retreat from the regulatory blitz that followed the 2008 financial crisis, corporate governance—with an opposite and equal reaction—is attracting an unprecedented level of attention from investors around the world.
That is according to the 2018 Global Trends in Corporate Governance study, recently published by Farient Advisors, an independent compensation and corporate governance firm, and the Global Governance and Executive Compensation Group, a partnership of leading advisory firms from around the world.
Published annually, the Global Trends in Corporate Governance report gathers insights into corporate governance practices and patterns and their implications for company boards. The 2018 report covered 20 countries across six continents.
Regulatory rollbacks vs. shareholder activism
A major conclusion drawn by the report: “Governance standards become global when widespread corporate abuses and/or financial crises appear, shareholders feel unsure, and governments respond with more stringent governance regulations.”
At first glance, the past year might have seen a pullback in corporate governance standards, as elections and new governments in major economies signaled a shift toward less regulation.
In the United States, for example, the Trump administration is averse to overburdening companies with rules and restrictions. In Japan, Prime Minister Shinzo Abe’s government faces criticism that it has not fully supported efforts to reform the kinds of corporate practices that may have contributed to a succession of accounting and quality control scandals at Japanese companies.
As the report notes, however, regulation is not the same as good governance. “We saw no reduction in interest by regulators, shareholders, and the public in good governance in 2017 and we foresee none in 2018,” it says.
“Quite honestly, when we started work on the 2018 report we were concerned that we would see a revision in the momentum that was gaining for the past two to three years,” says John Trentacoste, a partner at Farient. “The U.S., one of the bellwethers of corporate governance and regulation, made a pronounced decision with the Trump administration’s posture toward regulation, that it is burdensome, and returning to a laissez faire view of economics is the approach they want to take.”
“When we peeled back the onion a little bit more, we realized that good governance does not stem from regulation. In most instances, it’s the fact that the shareholders are asking for good governance,” he added. “We continue to see plenty of evidence that investment capital is often swifter than government regulation in setting the tone for global corporate governance. Even when everything points to a thawing of regulation, investors have continued on their march toward good corporate governance policies and practices.”
The lesson learned is that money talks, especially as investors look beyond their domestic borders for investment opportunities. A prerequisite of attracting those funds, however, is soothing the nerves that traditionally would have found comfort in strict regulatory regimes.
The report illustrates a correlation between deregulation and shareholder activism. For example, the U.K. government has proposed new legislation on the reporting of pay ratios and long-term incentive plan outcomes. In addition, the Financial Reporting Council published proposals for revision of the U.K. Corporate Governance Code. The FRC intends to publish a revised U.K. Corporate Governance Code in June.
In August, the U.K. published new guidelines for executive compensation designed to strengthen its reputation as a leader in corporate governance in advance of Brexit, including a requirement that some 900 listed companies annually publish the pay gap between their CEO and their average U.K. employee.
In the United States, while President Trump continues attacking the Dodd-Frank Act, important provisions, such as the shareholder advisory vote on executive officer compensation (the “Say on Pay” vote) continue to enjoy support and are likely to remain in place. The newly passed Tax Cuts and Jobs Act restricts the ability of businesses to write off compensation expenses that exceed $1M for the CEO and other highly paid executives.
In Japan, the Abe government has quietly encouraged institutional investors to challenge management on investor relations and capital efficiency. In response to an assortment of high- profile missteps in the banking sector, Australia has increased its focus on governance, culture, and accountability. Its federal government introduced the Banking Executives Accountability Regime, which imposes significant regulatory oversight, and potential penalties, on banks, their directors, and senior executives.
“Where regulation is diluted or not enforced, investors seek to establish a best-practices baseline at the companies they hold, through lobbying, voting, and shareholder activism,” the report says. “Companies, markets, and governments are increasingly anxious to meet these demands, understanding that they are competing for a limited amount of global investment capital. At the same time, they are concerned to strike the right balance, avoiding regulations and norms of behavior that are too strict and thus encourage companies to domicile or list elsewhere.”
Governance momentum continues to build
The current approach to governance remains intense in most developed countries and moderate in Brazil and in developing Asian countries. Mexico continues to be viewed as weak.
China appears to be weak as well, but shows improvement. For example, the report notes that some Chinese state-owned enterprises are addressing governance issues by bringing in independent board members, giving greater authority to these boards, and promoting mixed ownership structures.
Another important advance will take place in 2018, when renminbi-denominated A-shares in Chinese companies, previously only available to Chinese shareholders and certain select foreign institutions, are added to the MSCI Emerging Market index, readily available to non-Chinese shareholders.
“When we peeled back the onion a little bit more, we realized that good governance does not stem from regulation. In most instances, it’s the fact that the shareholders are asking for good governance.”
John Trentacoste, Partner, Farient Advisors
“The change is welcomed by foreign shareholders, since A-shares generally trade at higher valuations than B-shares, which are quoted in other currencies and are more,” the report says. It may also “further motivate Chinese companies to address issues of transparency, corporate governance, and government interference in company decision making.”
“China is continuing to figure it out,” says Trentacoste. “We’ve seen some better disclosure coming out of China, whether that is directed by regulatory forces, or by the companies themselves, is yet to be seen.”
The three countries added to the study this year, France, Japan, and Saudi Arabia, are all experiencing a rise in scrutiny of their corporate governance landscape.
In France, shareholder outcry over the decision of the Renault board to confirm the CEO’s 2015 compensation, despite a rejection by a majority of shareholders, prompted the government to consider making Say-on-Pay (SOP) votes binding.
Japan, anxious to promote the return of foreign shareholders and move past the scandals that have hit leading companies like Olympus, Toshiba, and Takata, adopted a Corporate Governance Code in 2015 aimed in part at reducing cronyism on boards. While progress implementing the code’s guidelines has been slow, 96 percent of Japanese boards now have at least one outside director and 78 percent have at least two, while 55 percent of listed companies now conduct formal board evaluations.
Saudi Arabia, undergoing a far-reaching economic overhaul designed to attract greater foreign investment, is paying greater attention to corporate governance.
In March 2017, its Capital Market Authority approved new corporate governance regulations for companies listed on the Saudi exchange (Tadawul). The new rules strengthen oversight by the CMA; enhance shareholder rights; clarify board, committee, and executive roles; and increase disclosure requirements. The timing of the new regulations is significant, as Saudi Arabia is preparing for an Initial Public Offering of state-owned Saudi Arabia Oil Co. (Aramco), expected to be the largest ever offering.
Governance standards also become global when widespread corporate abuses and/or financial crises appear, shareholders feel unsure, and governments respond with more stringent governance regulations.
Australia’s Banking Executives Accountability Regime is cited as an example of government response to poor corporate conduct.
“Most strikingly, our study finds that these developments have cross-border influence and can become global, although taking shape in ways that reflect local cultural differences,” the report says. In the United States, this heightened focus on making capital markets safer and more attractive for investors began with the passage of the Sarbanes-Oxley Act in 2002 and the Dodd-Frank Act in 2010, followed by regulatory actions on remuneration in the United Kingdom, the European Union, Australia, and Switzerland.
While voting is an important way for shareholders to influence corporate governance, voting rights are by no means universal, the report says.
Shareholders commonly vote on director elections, equity incentive plans, auditor elections, executive and director compensation (often referred to as “remuneration,” both of which terms are used in this report), and shareholder rights. Shareholders generally do not vote on matters of board structure.
While many countries have mandatory SOP votes, almost half of those we studied make them voluntary. Even in these countries, the prevailing best practice is to hold annual votes. For example, 80 percent of Canadian companies traded on the Toronto Stock Exchange hold annual votes on executive pay, although they are not required to do so.
Board structure and composition
Almost all countries the study researched have requirements or commonly accepted practices for board and committee structure, and most have rules or standards for board independence. The exceptions are largely developed countries such as Germany, Belgium, and Sweden, rather than developing economies.
The majority of countries, however, do not require that their exchanges adopt requirements covering director diversity, director term limits, director attendance, director age limits, or the board’s ability to control its advisers. Only one country, France, sets director age limits by statute.
Non-statutorily driven, commonly accepted/best practices have emerged from a broad cross-section of sources. “Board and chair independence is considered one of the most essential features of board effectiveness, if not the most essential,” the report notes. Statutory requirements range from 66 percent independent (Brazil) to 25 percent (Mexico). In Saudi Arabia, a majority of directors must be either independent or nonexecutives. In many countries, either government or stock exchanges have independence rules around audit and, in some instances, compensation committees.
In Switzerland, banks have only independent members and no executives on their boards; non-financial Swiss companies allow no recent employees on the board.
Belgium and Germany have management committees distinct from the board, since employee and/or union representation on the board is deemed to harm independence.
In Australia, Canada, and the United States, best practice is for the CEO to be the only insider on the board.
In almost half of countries studied, separation of the chair and CEO roles is statutorily required. The biggest push for board independence is taking place in the United Kingdom and the United States, where more than half of board members must be independent and the audit, compensation, and nominating committees must be entirely independent.
Few countries have statutory requirements regarding board composition. Best practices are emerging, but vary. In Brazil, Sweden, and the United Kingdom, age limits are prohibited, as they are deemed to be tantamount to age discrimination.
Limits on director tenure often tend to be company-specific, according to the report. In Saudi Arabia, directors with over nine years’ service do not qualify as independent for purposes of meeting quotas on the board and committees.
Board-member diversity has also become a hot topic. Statutory requirements pertaining to gender diversity exist in Belgium, France, Germany, India, and Norway, while best-practice norms for diversity, broadly defined by gender, race, ethnicity, age, and skills, tend to be supported in Australia, Brazil, Canada, Singapore, South Africa, Sweden, Switzerland, the United Kingdom, and the United States.
At Japanese-listed companies, women hold only 3 percent of directorships overall, but among outside directors, they account for 22 percent.
While governance trends may follow similar patterns, Trentacoste cautions against expecting carbon copy policies.
“A term that is thrown around too often and too loosely is ‘best practice.’ I think there are some things that are unequivocally best practices, but there is a lot of gray area when it comes to overall board governance and it really needs to be tailored to the company,” he says. “The burden is on the company to explain to its shareholders why the decisions it has made are in the shareholders’ best interest. That dialog needs to happen continuously and fluidly.”